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Small Business

How to Determine Employee or Independent Contractor Classification for Small Businesses

July 14th, 2016

A small business can hire employees or independent contractors to work for the benefit of the company. It is important to understand the difference between the two because:

  • With independent contractors, a small business does not need to match social security or medicare taxes, nor contribute to unemployment or worker’s compensation insurance, along with other applicable labor rules and employee benefits requirements. Therefore the business does not have to pay, manage and report employee payroll and employee payroll taxes.
  • The independent contractor loses out on potential employee benefits, certain labor laws protection, unemployment insurance, and possible employee retirement benefits.
  • The IRS can impose fines and demand all applicable back employee payroll  taxes for employees misclassified as independent contractors. The company may also face lawsuits from the misclassified workers for large sums of settlements, such as in the recent cases of Fed Ex and Uber drivers.

The determination is not based on the type of work. For example, plumbers or electricians are often independent contractors that perform services on demand. They can also be employees performing the same services, but for their employers only.

It is not based on the location of work either, a plumber can be an employee of a repair service company, perform repairs for its clients everywhere.

The IRS has published guidelines with various tests to determine the proper worker classification, though the key concepts focus on control, working relationship, and compensations.

If the company defines the working schedule, location, tasks, methods, training, tools, or reports for the worker, the worker is probably an employee. A contractor is contracted to perform certain tasks, though the company often does not control every step of the process required to complete the tasks.

An employee has a continuing relationship with the company, while an independent contractor works on contracts. Employees can quit or be terminated, though independent contractors are not terminated unless the contractors are terminated.

Independent contractors are often paid for partial or completed contract tasks while employees are paid by the hour, week, month or time and compensation as agreed upon hiring.

Understanding the key factors, the rest may be common sense. For example, an architect commissioned to create design drawings is a independent contractor, who delivers drawings to meet the company specifications. If the architect is required to work in the company office, at a fixed schedule, to prepare drawings as demanded, from project to project and is paid for the hours worked, then the architect is probably an employee after a certain period of time.

A person working part-time (Christmas help, etc.), meeting the criteria of employees, is still an employee. The employer is obligated to follow all rules to withhold payroll taxes, pay payroll taxes, and report payroll taxes accordingly.

Other examples include a nanny or household employee that needs to be treated as employees. There are a lot of paperwork and requirements for employee payroll tax withholding, payroll tax deposits and payroll tax reporting. For certain types of employees, there may be less reporting and deposit requirements, though the same employer responsibilities need to be met with even just one employee.

Statutory employees (insurance sales agents paid by commission, e.g.) are independent contractors under common law rules, though they are treated as employees by statute for certain payroll taxes purposes. Real estate agents also earn commission though they are Statutory non-employees.

In summary, it may be easier and possibly cost effective to treat workers as independent contractors. Still, the company needs to understand the difference between the two and be in compliance accordingly.

It is fair to classify workers correctly and it may be tedious but it is not difficult to manage employee payrolls once you understand and find a good tool or service to process payroll tax withholding, payroll tax deposits, and payroll tax reports.

We are here to help. If your small business is ready to bring on an employee, Paycheck Manager is one of the best small business payroll software, helping you manage employer payroll and employee payroll taxes.

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